Loan Rangers

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IN MOST financial crises private equity is part of the problem. During a typical credit cycle it is among the first to use cheap financing to buy companies. Buy-out firms gradually become trigger-happy, overpaying and loading businesses with so much debt that some of them go bust. After the crash, the industry is in disgrace and skulks away to bind its wounds. Years later it returns, penitent, wiser—but hungry once again for cheap loans.

In this financial crisis, however, private equity thinks it is part of the solution. Buy-out firms have struck lots of dodgy deals, certainly, but they are still rich and ambitious. And amid the financial wreckage of the credit collapse, private-equity partners think they have spotted a chance to make a lot of money by helping Western banks to repair their tattered balance sheets.

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This strategy partly reflects private equity’s fund-raising before the credit crunch. Back then, pension and sovereign-wealth funds were not just sipping the buy-out Kool-Aid, they were swigging gallons of the stuff. As a result buy-out firms still have almost $450 billion of their cash to invest, according to Preqin, a research firm.

The boom also fed buy-out firms’ aspirations. No longer are they content to act as Wall Street’s vigilantes, picking off the weak and the stray. Most now have high fixed costs, in the form of hundreds of employees. Their ageing founders long to diversify their firms and propel them into the top ranks of the financial establishment.

So private equity has the ambition to rescue ailing banks and it has the money. But does that make it a good idea?

A brief history of timing

To understand how private equity reached this position, consider the long-term prospects of leveraged buy-outs (LBOs), its core business. In 2006-07 the industry binged, buying companies with an enterprise value of $1.4 trillion. After adjusting for inflation, that is the equivalent to one-third of all the LBOs ever. Denial and rose-tinted accounting mean that losses on these investments have yet to be fully recognised. But the shares of listed buy-out funds are trading far below their book value and some clients, anticipating losses, are reportedly considering off-loading their interests in LBO funds.

The academic evidence for the private-equity industry’s historic returns is unclear. After fees and adjusting for leverage, the industry’s performance is similar to that of publicly listed shares (given that both asset classes own companies’ equity, this should not come as a surprise). But the poor deals at the top of the market could skew private equity’s record downward.

Optimists argue that credit markets will eventually recover. They also point out that the fall in stockmarkets means more bargains are available. Yet that is for later. In spite of all the equity it has to invest, the buy-out industry cannot now raise the debt it needs for large transactions. The banking crisis and sickly markets mean that there are no big loans to be had.

In any case, lower stockmarkets must be cold comfort to big clients like pension funds and sovereign-wealth funds, which saw private equity spend their cash at the top of the cycle. The shadow cast by those boomtime deals is one reason why, even if credit conditions improve, big clients may view LBOs with jaundiced eyes.

Private-equity firms could always hand back their clients’ cash. That may yet happen, but they have every reason to resist. Many, including Kohlberg Kravis Roberts (KKR) and Apollo, plan to follow Blackstone and list their shares. That is hardly the time to be shrinking the assets they manage. In addition, a chunk of their fees is usually charged as a percentage of the capital they manage, regardless of whether it has been put to work. And most firms lock away cash for roughly a decade in funds that typically need a supermajority of investors to unwind them. Clients are complaining, but not that much.

This leaves a neat coincidence. On one side of the financial system are buy-out firms with ambition, long-term capital, discretion about how to invest it, and a dearth of opportunities to invest in industrial companies. On the other are banks, desperately short of capital and liquidity. It does not take a billionaire buy-out barbarian to put two and two together.

So buy-out firms are redirecting their buy-out funds towards financial assets and they are also raising new funds. Preqin estimates that a further $40 billion of new distressed-debt funds is waiting to be deployed. At the same time, big firms have been adding to their credit teams by buying fixed-income talent. In January Blackstone bagged GSO, a distressed-debt-management firm. Credit has already become a big part of the assets the leading firms manage: between a quarter and a fifth for Blackstone, KKR and Apollo.

Understandably, the first deals with banks have been close to home. Most buy-out firms have started by buying the distressed loans that banks issued to fund LBOs, many of which trade at 70-80% of face value. Only a few big deals have been made public: Citigroup’s sale of $12 billion of debt to TPG, Blackstone and Apollo, for instance. But behind the scenes the activity has been frenzied.

Chris Taggert, of CreditSights, a research firm, estimates that the overhang of LBO loans that banks are waiting to sell on to investors has shrunk by $192 billion from the peak, to just $45 billion today. That chimes with the banks’ own disclosures. An analysis by The Economist suggests that the amount of corporate junk debt on the balance sheets of ten of the largest banks in the loan markets had fallen by $205 billion, to $163 billion at the second quarter.

Hoovering up these loans makes sense in some ways. Buy-out firms are familiar with the debtor companies—they probably either control them or cast an eye over them during the boom. And the banks are so desperate to get these loans off their books that they provide financing, typically two-thirds of the purchase price, at low interest rates.

Take the high yields on the distressed loans and supercharge them with cheap debt and the internal rates of return look impressive. Blackstone has said it expects returns of 20-30% on the equity it has invested in LBO loans.

Yet there are risks, too. In buying LBO loans, the industry is doubling up its bet on a small pool of companies. Executives may believe in these businesses, but many of them are too indebted to cope with a downturn. Lately, the economy “has become a much higher concern” for loan traders, says Mr Taggert, which perhaps explains why loan prices have not recovered as the overhang of supply has shrunk. Most of the bank-financing packages stipulate that, if prices fall further, private-equity firms must post margin calls. And if the companies need to be recapitalised, it could lead to some toxic conflicts of interest—should debt investors be favoured over old equity investors? Can money raised for new buy-outs be used as equity to bail out old ones?

Even if LBO loans make money, they are more like a junk-food snack than a substitute for private equity’s staple diet of industrial companies. The supply of new loans is now limited, as many banks plan to keep the remaining exposures on their balance sheets. Most of the return from a typical LBO-loan deal comes from leverage. In the long run, clients are unlikely to pay high management fees for that.

From owing the bank to owning it

One alternative to buying banks’ loans is to buy their holdings of the securities at the heart of the crisis—structured-credit products backed by mortgages. Blackstone is talking to “several institutions” about buying mortgages. Last month Merrill Lynch offloaded a pile of collateralised debt obligations at a knock-down price of $7 billion, or 22% of their face value, to Lone Star, a private-equity firm.

But Lone Star has a history of specialising in finance and such deals are unusual. When UBS auctioned a portfolio of securities backed by “Alt-A” mortgages in May, it received little interest from private-equity firms. This may be because these securities are highly technical. In addition, they are passive investments that do not call for the operational management where private equity thinks its skills lie.

For mainstream private-equity firms, the promising business may lie elsewhere: buying into banks themselves. Banks certainly need capital. Writedowns have reached a total of $500 billion, according to Bloomberg, but big lenders have raised only about $200 billion of tier-one capital, the Bank of England estimates. America’s Federal Deposit Insurance Corporation, which monitors sick banks, now has 117 lenders on its watch list, compared with only 90 at the end of March.

This is not for the lily-livered. Banks are the original highly leveraged investments. Valuing them is tricky—just ask the sovereign-wealth funds that have lost money investing in them over the past year. Or TPG, which has lost money in Washington Mutual, an American lender, and ran into controversy when it got cold feet about bailing out Britain’s Bradford & Bingley.

Yet some specialist private-equity firms have pulled it off. Lone Star turned round two Asian lenders, Korea Exchange Bank and Toyko Star Bank. On August 21st it said it was buying IKB, a German corporate lender that had made a disastrous foray into American subprime debt. And expertise can be bought. One executive thinks it is “relatively straightforward” to assemble a team with the operational and financial skills to run a bank. Big firms including Carlyle and TPG are now thought to be hiring the people they need.

The hurdle in America is regulation. The Bank Holding Company Act, which governs most big deposit-taking institutions (although not broker-dealers), stipulates that a voting stake in a bank of 25% or above constitutes control, whereas a holding of less than 5% does not. Between these two thresholds is a grey area that the Federal Reserve has interpreted conservatively, taking into account, for example, whether the owner can appoint directors or owns non-voting capital too. Control of a bank brings responsibilities—more supervisory oversight and the “source of strength” obligation that can require a holding company to inject capital into ailing bank subsidiaries. No private-equity firm wants to sign a blank cheque, and few would welcome regulators crawling over their books.

Before private equity takes the plunge, the rules may need to be tweaked. As early as next month, the Fed is expected to offer more guidance on the grey area of the ownership thresholds, probably relaxing its stance. Private-equity firms are also lobbying for the rules to loosen, so that they can form a consortium of buy-out firms without being deemed to have formed a “concert party” that has taken control. They also want permission from both the Fed and their clients to ring-fence the funds that invest in banks, so that their wider activities are safe from banking liabilities.

Will private-equity firms ride to the rescue of banks? Buy-out firms are unlikely saviours, but private equity’s $450 billion war chest is big enough to fill Western banks’ capital shortfall. There are few other sources of ready capital. Sovereign-wealth funds have been badly burnt; banks cannot easily raise equity in public markets; and the atrophy in many of the biggest lenders leaves them in a poor state to buy the weakest.

So regulators in America and elsewhere may feel obliged to ease their ownership restrictions. Until this year private equity had stuck to form, recklessly buying industrial firms at the top of the credit cycle. But the industry’s next guise could be less familiar—and more welcome. Private equity, saviour of Western banking. Who would have thought it?